How to Tax

Paul Graham recently posted (though apparently wrote some time ago) an interesting piece on the distribution of wealth. In the essay, he argues that variations of income can be a sign of progress, once past a certain tipping point. He justifies this by correlating the growth of income variability to the growth in productivity variability that is inherent in the invention of more productive techniques. Beyond the opportunity for productivity variation there is also the amplification of skill value that enabling technologies provide.

He ends with:

You need rich people in your society not so much because in spending their money they create jobs, but because of what they have to do to get rich.

I find this quote interesting because it comes very close to hitting a point that Paul missed or omitted. Paul speaks entirely of income, and not the use of income. There is an old saying, “Money is power”. It may not be an absolute truth, but in society, it is essentially true. Attached to this saying is a stigma that stems from well known abuses of power.

I see a different side to this saying that may provide insight into a better way to deal with some problems resulting from an income gap. One problem is, very wealthy people have many opportunities to waste resources in an unproductive manner. Not all wealthy people do. In fact, many don’t, especially those who made their fortunes through business. Often, successful business people understand waste, and have a natural aversion to it. This quality improves the chance of business success, so you’ll find it more often among wealthy business people than wealthy actors or professional athletes.

When an actor carries out a performance for a movie, there is definitely some form of wealth, in the form of entertainment created. But it’s highly debatable if that value is greater than the waste generated. When actors take their earnings and use them to buy custom made cars, huge mansions, private jets or worse, drugs, is there really enough value in the performance to justify all of that waste?

In theory, you’d say yes because people are paying for it. But in reality, we know what people pay is not directly enough related to real value to be more than a vast generalization. Commodity markets, that trade in tangibles like corn, oil or lumber struggle to find the real value of these commodities. But even in these markets, which have a clear purpose, and an attentive set of purchasers, this value is hard to determine and varies drastically from one day to the next. In consumer goods, the consumer is less attentive, the purpose less clear, and the products often more abstract. This suggests consumer good prices are very loosely related to real value.

Money as Power

The income of the wealthy is not all directed towards waste. Many business people put money back into their business, or other’s businesses. This investment is one of the most important factors toward economic, technological and even social progress. Many people assume the only reason wealthy people invest is to make more money, so they can waste more money. But that simply is not true. Many investments are only about money, but many investments are made because of a belief in the value of a certain endeavor toward progress. It is a side effect that if an endeavor has real value, it will generally be able to make money.

Sure, the wealthy who manage businesses could price goods such that they don’t make money, but in general, this doesn’t make sense. For one, what about the next endeavor? Money will be necessary for that, perhaps more money than the first. Second, it’s simply easier to manage a business in a way that wastes less than a charity. Third, if you don’t plan to make money, it’s very difficult to get help, from other investors and banks, when you need it. As a charity, you must rely upon either the government or individuals. If you’re having problems with waste already, those entities will be less interested in your cause.

The use of wealth for investment is beneficial to society. Products still get purchased and wages paid, but the difference between spending money on new business endeavors and spending money on a lavish lifestyle is that one has a positive value, and the other negative. I’d hold that the concept that consumer spending is the most important factor in an economy is inherently flawed because it fails to consider that businesses buy computers, desks, chairs, office space and all other manner of manufactured, invented or other goods.

The problem is people who think of investment this way are a minority. We are lucky the laws of business ensure this type of person is more likely to become wealthy. For people like this, money is the power to encourage change, or the power to create progress. Even among the wealthy, this type of person may still be a minority; it’s hard for me to say. We hear about ostentatious types more often because they make more interesting news stories.

Using this Knowledge

I don’t think an income tax is the most socially advantageous way to collect tax. Income does not measure your burden upon society, or your benefits from society. Income is a measurement of societies benefit from you. It’s an imperfect measurement, but the general principle is true. As Paul says, what you do to earn income is what society needs. What society doesn’t need is your waste.

It makes more sense to tax personal purchases, personal holdings (houses, cars, boats), and not tax things associated with the creation of wealth. Consumption taxes like a sales tax or a value added tax, are one form of such a tax. Another type is a property tax.

The traditional problem with consumption taxes is, when applied naively they are regressive because the poor need to use a greater portion of their income on purchases then the wealthy.

By Good

Consumption taxes can be more progressive by taxing different goods differently. Excluding food is one example. Additional taxes on luxury items are another. But regulations of this type are very hard to properly manage. The number or products needing classification is staggering, and difficult. Should $150/oz beluga caviar be taxed? It’s food, but it’s also a luxury. How about $2.50/oz American Salmon Roe? Also, many goods are used by poor and wealthy, but the wealthy use disproportionately more. Gasoline is a good example.

Taxing goods differently has not done enough to satisfy society’s desires for progressive taxes.

By Income

Consumption taxes can also be more progressive by taxing individuals differently depending upon their income. In the past, such a system would have been very difficult to administer, but today, the electronic nature of almost all purchases makes it much more feasible.

This system could be administered by distributing a card to all households based upon the prior year’s (or month) income. When purchases are made, the card would be presented and would determine the tax rate. The card would not need to be personally identifiable, but privacy concerns would still exist.

Also the concern of card-swapping or proxy purchases would be problematic. The only way to address these concerns would be monitoring that would raise additional privacy concerns.

However, the consumption tax would be truly progressive, and would encourage investment in the future. The ostentatious would be appropriately penalized, while the visionaries would not.

By Consumption

Consumption taxes can also be more progressive by applying a higher tax rate as an individual’s consumption increases. Taxes would increase non-linearly with consumption. For example, spending $4,000 in a month might trigger a 15% tax rate, or $600 in tax. Spending $10,000 in a month might trigger a 25% rate, or $2,500 in tax.

However, many of the same concerns as by income apply to by consumption. Privacy concerns would be even greater because the tax agency would need to have a record of every purchase you made in order to calculate how much you spend. Card-swapping and proxy purchases would still be a problem, though less so since use would raise the proxies tax rate for all purchases. The necessary information for monitoring would already be supplied to administer the tax rate, but that doesn’t relieve the associated concerns at all.

On the other hand, a by consumption tax would just as progressive as by income with the benefit of a greater scaling benefit in encouragement of investment among the wealthy.

By Non-Savings

It’s also possible to attack the problem from a different angle. Under the current income tax system, general savings are taxed. There are some exceptions to this rule, such as IRA’s. If these exceptions were expanded to include all investments in stocks, bonds or deposits to savings accounts then you would have a system similar to the by income system. In theory one might think that this would benefit the rich disproportionately, but by adjusting the actual brackets and rates appropriately, it could be brought into line existing social goals.

Other Characteristics

In addition the basic rate system, certain exceptions may be desired based child raising or other socially protected situations. In most cases the most reasonable solution is a deduction, credit or rebate rather than an altercation of the tax rate. An example of this is the FairTax rebate plan.

Summary

I admit, some of the later systems I list are radical. I like radical ideas. They are interesting and challenging to think about. But I’m a realist too, and I realize that the radical takes time to accept and thought to mature. But some ideas are at least less radical and possibly stepping stones to something even better.

The FairTax plan is a simpler, but still effective framework that would be a major step in the right direction. To the average American it might still seem radical, but many other countries around the world, especially in Europe, rely either very heavily or entirely upon a consumption tax. Also, our state and local governments collect revenues from consumption taxes today. This means a simple consumption tax like that of the FairTax plan is not an untested concept.

A great deal of the FairTax plan appears to be designed to hold other variables constant where possible, and thus increase its political viability. It certainly could be improved upon, but its structure is not designed to be perfect, but rather a cautious improvement. As political compromises go, I see the rationale behind it.